Monday, July 23, 2007

The Tragedy of the Commons is a concept that refers to the use and ultimate damage done to resources that belong to the public. Here is how it works on a simple economy basis:

An economy consists of a single village. Each resident attempts to gain wealth by putting as many animals on the common pasture of that village as it can. As the village grows in size and more and more animals are placed on the commons, overgrazing begins to impact the pasture. Eventually, no stock can be supported on the commons. As a result of population growth, greed, and the use of the commons, the village collapses.

It occured to me that this concept can also be applied to what is happening with sub prime lending and credit in the economy. Banks and others would make loans and then the loans would be securitized and sold off. The purpose of the securitization was to minimize risk by removing that risk from a lenders balance sheet, etc.

It instead has the opposite effect - by redistributing risk - it increased risk because it made no one responsible for that risk. The risk was distributed to the "commons." A lender could make a bad loan and it wouldn't matter because that loan would be sold off to the marketplace. It is analogous to a common grazing site in a small village as described above.